I am a director of several funds
and often - along with some other board members - I am also
responsible for the investment strategy of these funds. Usually, board
members and advisors have very little to say in terms of the how the
funds invest because it is the investment manager's responsibility to
perform and, therefore, it is very difficult for a board member to
interfere in the investment decisions of the fund manager. However, in
the case of some funds the board members or the advisory board are
responsible for a fund's asset allocation. In other words the board
members will decide at periodic meetings - usually quarterly - how
much of a fund is invested in equities, bonds and cash. Of course, board
members will seldom agree with each other, what percentages should be
allocated to these different asset classes and so, a compromise will be
reached, which will, therefore, neither turn out to be "right" nor
totally "wrong". However, the consensus decision will never be
entirely satisfactory. In addition, it has been my observation that
board members and the funds' investment managers become very
optimistic after an extended period of stock market strength and very
pessimistic after a period of extended weakness. When the market has
been strong for a while these "experts" will find hundreds of
fundamental reasons why the market is strong whereas when the markets
has declined for a while they will list hundreds of reasons for caution
and for reducing the exposure to the market.

In the 1970s, the most admired technical analyst was Joe Granville. As
incredible as this may sound, Granville caught every stock market move
of more than 10% up or down within a few days of the turning points from
up to down or from down to up. The result was that at the end of the
1970s, the entire world was watching Granville's buy and sell signals.
In fact, for a brief period of time Granville's buy and sell signals
would move the US stock market - at least temporary. Granville's
demise as a market guru then followed. In 1982, he failed to realize
that a secular bull market in bonds and stocks had begun and remained
bearish. So, in the early 1980s he totally lost his credibility and his
following. Still, to Granville's credit, I must point out, that he
turned extremely bullish on the stock market after it had collapsed by
40% between August and October 1987 culminating in the famous October 19th,
1987 crash during which the Dow dropped by over 21% in one day! Also,
whereas Granville fell on hard times after the 1970s and is, today,
hardly known among the investment community, his books on technical
analysis are outstanding, in terms of his insights into what factors
move markets. They are also entertaining, and easy to digest. In my
opinion, one of his most important words of wisdom is that markets will
always move ahead of the news. When a stock or any market begins to act
well, while the news is extremely bleak, the market may be indicating
that some improvement is around the corner. Conversely, when a stock or
a market begins act badly, while the news is still extremely bright, the
market more often than not is telling you that the fundamentals may be
about to deteriorate. Basically, Granville's view is that "news"
is bunk and that the market will have responded to favorable or
unfavorable news long before the news comes out into the open. In other
words, you should invest when everything looks horrible and when nobody
can see how fundamentals could improve, while selling is advisable when
the sun is out and everything looks rosy. As Granville pointed out, an
investor should basically stand on his head!

I am mentioning the fact that news will always lag investment markets for
a number of reasons. First of all when I look at today's inflated
asset markets, the late 1970s and early 1980s come to my mind when all
investment markets were - with the exception of the commodity markets -
extremely depressed. After the experience of high wage inflation in the
1960s and accelerating consumer price inflation in the 1970s, stocks and
especially bonds were extremely inexpensive in the early 1980s. In 1981,
long term US government bond yields rose to over 15% and 3-months
deposit rates were above 20%. Therefore, nobody in his right mind wanted
to touch bonds - not even with a barge pole since higher yields were
available on short term deposits than on bonds. Also, the common view
was that bonds were "certificates of confiscation" as consumer price
inflation was here to stay and that it would continue to erode the value
of bonds. Most of my clients argued "why buy bonds at 15% yield when
one can get 20% interest on riskless short term bank deposits"? In
addition, with the Dow Jones hovering around 800 - no higher than in
1964 - nobody even believed that Robert Prechter might be right when
he predicted in his first book on the Elliott Wave Theory, published in
1978, that the Dow would rise to 2,300 (in a subsequent edition he
revised his forecast to 2,700). The preference for cash and commodities
(in particular gold) was also evident from the inflows into equity
mutual funds. In the 1970s - with the exception of two months - mutual
funds suffered net redemption every month! Moreover, by 1982, cash
positions at US mutual funds rose to over 15% compared to around 4.5% at present.

Today, on the other hand, it seems as if investors had thrown any caution into
the wind. Cash returns are so low - courtesy of Greenspan's ultra
easy monetary policies that the entire world is "investment mad".
Investors all over the world are hunting for investment opportunities
the way gold diggers were rushing to California during the great gold
rush of the late 19th century. Based on low inflation figures
investors buy bonds, due to the incremental demand from China they buy
commodities, because of record S&P earnings, an expanding global
economy, and the belief that stocks go up anyway by about 10% per annum
in the long run they pile into stocks, and finally because "you cannot
lose on real estate over time" they rush into properties all over the world.

So, what I am thinking is that while the early 1980s represented a lifetime
buying opportunity for financial assets and real estate, today, we may
be at a lifetime selling opportunity for financial assets and real
estate (not necessarily in Asia). The reason for the strong performance
of asset prices over the last 20 years or so is that, in the early
1980s, consumer price inflation shifted to asset inflation, which
changed the rules of the investment game whereby investors were not
alerted by this change of rules. So, if in the early eighties, consumer
price inflation could, out of the blue, begin to shift from consumer
price inflation into asset inflation without investors actually
perceiving this shift to become a permanent feature of the following two
decades, why could, now, or in the near future, asset inflation not
begin to shift back into consumer price inflation - this against all
expectations?

In last month's report, I quoted my friend Bill King
extensively who showed how the US government fudges economic statistics.
A few days ago, Bill provided further evidence of the government's
manipulation and misrepresentation of statistics - this time for the
case of inflation figures. Bill quoted a study by Tom McManus of Bank of
America securities who showed the composition of inflation. As can be
seen from figure 1, the Bureau of Labor Statistics (BLS) calculated that
health care inflation in the last ten years or so averaged about 4% per
annum. However, from private studies we know that health care costs have
risen by around 10% per annum in the last few years. Moreover, whereas
the weighting of the BLS's health care expenditures within the CPI is
only 6%, health care represents about 17% of consumption (see figure 2)
And this, so Bill King points out, according to the Bureau of Economic
Analysis of the US Commerce Department. I think there is no better
example to expose the US government's continuous lies about the health
of the economy. By understating the rate of CPI inflation the bond
market is being fooled and real GDP growth rates artificially boosted
since real GDP is nominal GDP less the rate of inflation. So, if nominal
GDP increases by 6% and inflation instead of averaging 3% per annum is
in fact more likely to average 5% per annum, real GDP growth is not 3%
but 1% per year!

As a side, I may add that I have always been skeptical about buying
inflation adjusted bonds (TIPS), simply because the yield on inflation
adjusted fixed income securities is pegged to the CPI. Since the
government will always understate the true rate of inflation the buyer
of the TIPS will eternally be shorthanded. Moreover, I think that one
day in future, the bond market will finally wake up to the fact that
inflation has been understated and sell-off very badly. In fact, you
would have to be the world's greatest optimist (a la Abby Cohen or
Larry Kudlow) to buy a US 30-years government bond in US dollars and
with a yield of just 4.5% with the view to hold these bonds to maturity.
You would have to assume that US inflation will never rise above 4.5%
within the next 30 years and that the US dollar's purchasing power
will be maintained. Not a likely scenario, in my opinion (short term,
however, bonds could rally somewhat more as the economy weakens).

But
there is another reason why I started out by talking about markets
moving ahead of news. Recently a board member of one of the asset
allocation funds, for which I am also an advisor, wanted to double the
equity allocation of the said fund based on an economic study he
circulated (naturally produced by a self serving investment bank), which
showed that the global economy was strengthening and that profit growth
would remain strong. Now, I am not necessarily arguing here that the
study is wrong. Who knows?? But, a strengthening global economy may be
"old news" as far as the US stock market is concerned and not lead
to rising stock prices. The market may have already discounted this good
news through its rise since April.

Moreover,
if I look at the recent performance of important stocks in terms of
their market capitalization, such as Wal-Mart, GE, IBM, Citigroup, Dell,
and financial stocks in general, which are all weak, the stock market
seems to say the opposite from what the bullish economic study is
suggesting...

And
quite frankly, if I have to make a choice between who to trust more -
the market action or the forecasts by strategists, economists and
analyst, I take the market's forecasting ability any time. I should
also like to add that recent weakness in sub-prime lenders and
homebuilders hardly suggests that the credit driven economy will
strengthen in the next six months. Corporate profits are, therefore,
likely to disappoint.

A last point: Given the devastation in the Gulf of Mexico, the "always
easy" and disastrously interventionist Fed is likely to stop raising
interest rates soon. This will be reflected in the US dollar resuming
its downtrend and gold rising further.